Saturday, November 27, 2010

We're all paying a high price for hiding our debt

IT DOESN'T seem to have occurred to Julia Gillard that her resolve to make this the "decade of infrastructure" - with a gold-plated national broadband network as its centrepiece - doesn't fit with her core promise to return the budget to surplus in 2012-13 and eliminate government debt ASAP.

Indeed, the two policies laugh at each other. Both Gillard and Kevin Rudd succumbed to Costelloism - a brand of fiscal populism holding that all government debt is bad - as did various state Labor governments.

The upside of this abhorrence of budget deficits and obsession with the elimination of debt is it left the Rudd government perfectly placed when it needed to spend big to counter the impact of the global financial crisis.

The downside is it led to more than a decade of inadequate spending on infrastructure. Labor made much of the neglect of infrastructure while in opposition and this explains its resolve to give it a high priority. But Labor has also embraced the very mentality that caused the problem.

As Dr Nicholas Gruen, of Lateral Economics, has written in a report for Western Sydney councils, the obsession with debt may have got rid of the budget deficit, but it exchanged it for an infrastructure deficit. In truth, only some government debt is bad. It's not bad when it arises from deficits incurred during recessions. And it isn't bad when it arises from capital spending - provided those capital works are worthwhile. It is bad when it arises from the failure of governments to ensure their recurrent spending is covered by revenue during normal years.

I'm a great believer in the (Peter Costello-introduced) "medium-term fiscal strategy": to "maintain budget balance, on average, over the course of the economic cycle".

You'd never know it from the way Costello and his successors carry on, but that strategy is carefully worded to permit the budget's "automatic stabilisers" to push the budget into deficit during major downturns and also permit governments to use the budget to stimulate the economy during recessions.

So the addition of the words "on average over the cycle" makes the strategy - shock, horror - a Keynesian formulation. (Clearly, it was crafted by someone a lot wiser than Costello.) But the words "on average" make it a strictly symmetrical Keynesianism: once the recession passes you have to get the budget back to surplus and keep it there until the next recession.

There's just one weakness in this enlightened strategy: its failure to distinguish between capital and recurrent spending - that is, its failure to permit the federal government to borrow to fund infrastructure.

If Labor had a deeper understanding of economics and genuine belief in it, rather than a mere desire to portray itself as a "fiscal conservative", it would have had the courage to add that qualification to the strategy.

So how does Gillard expect to square the circle of tackling the infrastructure backlog without being able to borrow? I bet I know. She intends to use "public-private partnerships" to get the borrowing done by the private sector. Hey presto! Problem solved.

But hey presto is right. This is just creative accounting. The government initiates the need to borrow - and, directly or indirectly, guarantees the borrowing - but gets the debt put on someone else's balance sheet.

Unfortunately, the drawbacks of PPPs - which so far have been used mainly by state governments for all manner of infrastructure assets, from highways and railway stations to hospitals and desalination plants - are much greater than this.

As Gruen explains, these assets have been built at a higher cost to the public than would have been the case had they been built the way they used to be, as government-owned assets funded by borrowing.

The first cause of increased cost is the "artifice" needed to get private investors interested. They have to be reassured that some future action by the government - say, the building of a competing road or hospital - won't leave their asset stranded.

So the government has to tie its hands, promising not to do certain things and cutting off options for the future that may have been in the public's interest. And we've all seen how governments shore up private toll roads by "traffic calming" (making it harder for motorists to avoid the toll road).

But the bigger reason PPPs are so much more expensive is that government - being the government and thus having the power to raise taxes to cover its debts - can borrow a lot more cheaply than private businesses can. This is true even after you allow for the risks involved in specific infrastructure projects.

To illustrate the extra costs involved in PPPs, Gruen calculates that, had the NSW government chosen to fund the toll roads that now encircle Sydney, the state would have acquired ownership of a stream of revenue with a net present value of about $12.8 billion, at the cost of increasing its borrowings by $7 billion.

In other words, by taking on a little more risk, the state would have increased its net worth by about $5.8 billion. After allowing for that extra risk, its net worth would still be $4.6 billion higher.

By today, more than 60 per cent of the original borrowing would have been paid off, leaving a net cash flow to the budget of $380 million a year, after allowing for the interest payments on the extra debt and even after providing for further repayments of principal. And get this: in the unlikely event of the government's taking on of the extra debt prompting the ratings agencies to downgrade the state's AAA credit rating - which would increase the interest rates it had to pay on its borrowings - the budget would still be ahead on the deal.

Bottom line: the public is paying dearly for the efforts of governments to hide the debt they're responsible for.

Although we're not paying as much public debt interest as we would have been, we're paying inflated tolls on roads (as Gruen's calculations show). We're also paying heavy repayments on our mortgages partly because of governments' failure to release sufficient land and their loading of up-front infrastructure charges on the land they do release.

And we're paying with our time as we wait at peak hour in traffic that has slowed to a crawl or crowd into late trains and buses. All thanks to the demonising of government debt.